With the Fed funds rate hovering near zero, the Fed resorted to massive Treasury purchases in an effort to drive down interest rates and stimulate the economy, a policy which has made the central bank Washington’s largest creditor. Because all Fed profits are rebated back to the Treasury, the interest on the 12% of U.S. debt held by the Fed is being returned directly to the Federal government’s coffers and, by extension, to American taxpayers, since every dollar of interest the Treasury receives back from the Fed is a dollar it does not have to collect from taxpayers in order to finance the debt. Given that 20% of tax revenue goes to servicing this debt, that’s quite a break we’re receiving from Bernanke & Company.

Yet it gets better. Like disk jockeys programming an oldies station, the FOMC’s members recently brought back a blast from the past, the 1961 monetary policy sensation known as “Operation Twist.” In the September 2011 remix of this interest rate two-step, the Fed announced it would sell $400 billion of Treasuries with maturities of no more than three years, using the proceeds to purchase an equal amount of 6- to 30-year T-bonds. Given how low short rates already are, the idea is to lower rates at the long end of the yield curve by pushing out the maturity of the central bank’s holdings and taking longer-dated T-bonds out of the market. The theoretical argument is that lowering the long rates should stimulate the economy, while the counter-balancing short-maturity sales hold the size of the Fed’s balance sheet constant. A side effect of this kind of maneuver is that, as it skews the Fed’s holdings toward higher-yielding long Treasuries, the fraction of total interest on U.S. debt rebated to the Treasury by the Fed will increase even though the value of the Fed’s Treasury holdings are held constant. As an added bonus, those lower long-term rates mean reduced long term costs of further borrowing by the Treasury as it finances that ever-increasing U.S. debt.

All this may sound suspiciously like the free lunch your economics professors told you was but a culinary myth. But the tab’s arrival may be delayed while markets extract a higher price for the fiscal over-consumption of other nations. The Fed’s epic Treasury purchases are funded by money the central bank creates and injects into the markets, which, ceteris paribus, might be expected to depress the value of the dollar and increase inflation. However, ceteris hasn’t been particularly paribus lately; ongoing Euro-antics continue to place a safe haven premium on both the currency and debt of the United States (see “Send Treasury Your Retired, Your Not-So-Poor, Your Befuddled Classes Yearning To Invest Risk-Free…”) while, in the wake of the financial crisis, sluggish global growth has restrained increases in both labor and commodity costs. This trend has been reinforced of late by recent slowdowns in China and India, engineered by those countries’ central banks in the hopes of restraining their own domestic price pressures.

Nevertheless, the nascent recovery in the U.S. has been attended by a run-up in the price of oil and, recently, rising unit labor costs, causing the TIP spread between regular and and inflation-protected Treasury bonds to widen, albeit modestly. If, as some recent data from Beijing indicate, China’s landing proves to be more of a brief layover, and should concern over a full-blown Euro implosion continue its recent ebbing, then the U.S. may learn a truth diners at complimentary buffets generally discover: sooner or later, gorging on a seemingly free lunch is paid for with inflation, be it in your waistline or your currency. But for a Fed faced with the alternative of stalled growth, increased inflation risk may be, as the old saying goes, just the price of rice, converted or not.

Washington has had various factors to thank for the easy credit terms the world continues to offer. From Iranian saber-rattling to Japanese earthquakes, many forces served to drive frightened capital into the arms of the US Treasury market. However, at the top of the list is surely the political leadership of the Eurozone. The Obama-Boehner show has nothing on the extravaganza headlined by Merkel and Sarkozy, with a supporting cast of various and changing guest stars governing the solvency-challenged PIIGS (Portugal, Ireland, Italy, Greece and Spain) and of course the folks at the IMF and ECB (every comedy needs a few straight men and women, after all). This noisome cavalcade had provided a continuous flow of confidence-shaking news, keeping sovereign default risk and systemic shock ever present in investors’ minds. Meanwhile, the US has muddled through a budget deal which, while insufficient in the long run, indicated some capacity for concord even in the current poisonous political atmosphere. Similarly, the Fed, aided by TARP financing, seemed to succeed in stabilizing the American financial system. Through late in 2011, the result was an increase in the cost of euro-denominated borrowing for key large Euro sovereigns with the exception of Germany, the yield on whose bunds declined almost in lockstep with a simultaneous drop in US Treasury bond yields.

At the time of this writing, with the “voluntary” Greek debt restructuring talks dragging on, observers may understandably have a difficult time conceiving of an end to “Euro-fear.” Nevertheless, it is precisely the possibility that, with or without Greece in it, the Eurozone will find a way to get its house in some kind of order that threatens America’s ultra-low borrowing costs. We are in fact seeing some tentative signs of, as Churchill put it, not the end or even the beginning of the end, but perhaps the end of the beginning.

New ECB president Mario Draghi’s Long Term Refinancing Operation ostensibly provides a three-year, multi-hundred-billion euro stabilization line of credit to European commercial banks, but as the ECB is “allowing” (read: encouraging) those banks to use this credit to buy better European sovereign bonds (and avoid having to dump weaker Euro nation credits in bulk) what we’re really seeing is a back-door program to lower European states’ borrowing costs. Because the ECB loans represent money created by the central bank, this is a form of bailout that does not require direct taxation of “core” European nations citizens (e.g. Germans), though to be sure, they may end up paying the price through inflation (see “Europe Learns To Default The American Way, Restoring Transatlantic Balance Of Irresponsibility”) and devaluation, though export-driven economies like Germany actually need a weaker currency more than they might like to admit (“It’s Hard To Make That German Export Wiener Without PIIGS – And That Goes For Chinese Dumplings, Too”).

Second, whether or not the Greek debt restructuring talks result in a formal default or an effective one (and the contemplated 70% write-down will surely be a default in fact if not in name) is not so important as whether the process is orderly. So long as any any write-offs and triggered credit default swaps are handled in a way that does not lead to bank runs and frozen markets, such an event could be kept contagion free. There is no guarantee such a systemically benign scenario will play out, but the aforementioned willingness of the ECB to inject liquidity on a massive scale does provide reason for optimism.

And therein lies the rub for US government borrowing costs: as the Eurozone crisis subsides, so may the safe haven “panic bid” on US Treasuries, causing the yields on those bond to rise and further increasing the burden on American taxpayers of financing the deficit. Indeed, the 10 year US Treasury yield has crept up from below 1.87% in late November of last year to over 2.02%, while conversely (and despite it’s own rating downgrade), France’s ten year debt yield declined to below 2.90% since spiking above 3.73% during the same period. Similarly, the Italian 10 year yield dropped from over 7.36% to less than 5.49%.

To be sure, there are significant benefits to the US economy in this “risk-on” shift; the reduction in Eurofear has bolstered equity markets with a knock-on wealth effect boosting consumption and, yes, tax-revenue even in the absence of a rate hike. Even so, higher T-bond rates translate into an increased cost of servicing America’s heavy debt, so even if the core Euro countries seem to be picking up the tab, their Greek holiday may not come without cost for Uncle Sam.

N.B.: One advantage of a weakened euro – cheaper French wines (in dollar terms), and in particularly that said-to-be-excellent 2009 Bordeaux vintage; for insight into this and all things vino, check wine expert (and Duke econ grad) Jessica Bell’s very excellent webcasts at MyWineSchool.com.

A weaker euro means relatively cheaper prices for German goods in the currency of non-Eurozone trading partners, giving German exporters an edge in world markets. To understand this effect, one must first consider two histories: that of the euro since its birth, and of German exports prior and subsequent to that introduction.

For all its troubles, the euro has strengthened considerably since its first day of trading, January 5, 1999. It hit $1.19 that day, but by December 3 of the same year it fell below parity with the dollar. The currency has since risen over 40% to $1.4172 as of this writing (it hit a high of $1.5892 on July 7, 2008). Now this appreciation versus the greenback has occurred despite the presence of the PIIIGS in the eurozone, with all the systemic risk that their potential sovereign defaults pose to European banking and economic growth. Imagine how much higher the euro might trade were the PIIGS to exit Euroland’s pen, remaking the euro into something more in the image of the old German mark!

So how did German exports fare before and after it traded marks for euros? From January 1991 to January 1999, under the old mark (1991 being the first full year following reunification) German monthly exports rose from around 30 to 40 billion euros, an increase of about 4% per year. By contrast, in the euro period from January 1999 to January 2011 Germany’s exports rose to over 80 billion euros per month, an increase of over 6% per year (German exports dropped sharply during the ‘08-’09 financial crisis but have subsequently more than rebounded, hitting 97 billion euros in April 2011 before easing to 85 billion in September).

Would German exports have risen as sharply were the nation still using a mark, reflecting solely that nation’s monetary policy, as opposed to a euro in whose valuation German export strength, traditionally tight postwar German monetary policy and relatively conservative German fiscal policy are diluted by the PIIGS’ trade weakness and profligate budget policy, not to mention power sharing in the European Central Bank? I strongly doubt it.

To be sure, 60% of German exports still go to the EU, where the euro’s exchange strength would be irrelevant. But it is trade with China that is providing the growth in German exports, having risen four fold over the last ten years to rival the US as Germany’s largest single national market at 5.6% of the nation’s foreign sales, a figure that may triple by the end of this decade. This ballooning China trade is in turn driving German economic growth. Without the squealing PIIGS of the Eurozone’s periphery, a stronger euro could make German goods less competitive and have serious consequences for continued China-trade driven economic expansion.

There is perhaps some irony that, in addition to a “voluntary” 50% markdown in Greek bank debt, Europe is turning to China in hopes of having that nation finance some of the expanded $1.4 trillion European Financial Stabilization Fund, perhaps directly or through the IMF. Like Germany, China’s expansion is dependent on exports, and the global slowdown that could come in the wake of a euro collapse would threaten those sales. Meanwhile, Chinese inflation is still running high, driven by an undervalued yuan and tight commodity markets, so Beijing may also find continued euro-discounted German manufactured imports not unwelcome. And investment in euro assets provides China with some diversification from its substantial dollar holdings.

Chinese investment could at least lessen the need for debt monetization (see “Europe Learns To Default The American Way, Restoring Transatlantic Balance Of Irresponsibility”) and/or the issuance of Eurobonds directly backed by German taxpayers, perhaps under some kind of Eurozone fiscal union. That would be welcome news for Merkel. The former is anathema to a nation whose prewar experience with inflation had the darkest of consequences. As to the latter, Germany’s 83% debt-to-GDP ratio (it may hit 87% in short order, jumping from approximately 67% in 2007) is not at Greek or even American levels, but still speaks to Germany’s own bloated welfare state, which combined with past and potential bank bailouts, stimulus and Eurobond exposure to the PIIGS could yet make even German borrowing unsustainable, bringing us back to monetization and inflation.

So fortunately for Merkel, China seems to realize PIIGS are a desirable ingredient in dumplings as well as wieners. It remains to be seen if Beijing’s investments will eliminate or merely forestall the need for stronger measures. The Chancellor recently warned that the issuance of Eurozone debt and fiscal union would lead to “solidarity in mediocrity.” Yet when your export-led economy is partially built on the weakness of your currency partners, some economic convergence may be inevitable; a cruel truth, perhaps, but  then they don’t call it reversion to the “mean” for nothing.

The Wall Street Journal reports a Treasury Department claim that, prior to its decision to downgrade, S&P erred by essentially using a CBO “alternative” scenario for projecting the rate of deficits, as opposed to the “standard” baseline scenario. The result was a $2 trillion increase in the projected national debt over ten years (but hey, what’s a couple of trillion between friends?). This assumption would effectively counterbalance all but $400 billion of the $2.4 trillion in deficit reduction under the pact, providing only 10% of the $4 trillion increase S&P had warned would be necessary to avoid a downgrade.

According to the WSJ, when Treasury pointed out what it considered a “glaring mistake” to the rating agency, a “jarred” S&P decided to downgrade anyway, but changed the emphasis of their argument from the agreed-upon level of deficit reduction to “dysfunctional Washington political culture” and the “political setting.” In particular, S&P noted their pessimism regarding the challenge of making further progress in light of the difficulty of finding the narrow common ground achieved in the agreement.

Now one could be forgiven if one’s visceral sense of confidence in the republic is not bolstered by watching the President and Congressional leaders put on their version of a fiscal policy cage match. Yet realistically, had the debt ceiling’s increase been delayed, Treasury could have prioritized, servicing the debt and delaying payments for entitlements, employees, contractors and so forth. More to the point, a nation that borrows in its own currency and thus can print money to pay its debts presents little risk of default. This is precisely the difference between the United States and the individual members of the Eurozone.

To be sure, if monetizing the debt results in higher inflation, my view is that this constitutes a kind of real default (see “Europe Learns To Default The American Way, Restoring Transatlantic Balance Of Irresponsibility” and “The “Pained” Consumer Price Index”) but the risk reflected in credit ratings meant to be that of nominal default, of not getting back the currency you’ve loaned with the promised interest. What that currency’s future purchasing power or value in terms of other currencies might be for the future is an issue of great economic importance but beyond the scope of credit ratings, and for good reason. The nominal default of inflation and devaluation leaves the lender paid in the debased currency to service its own prior obligations fixed in that currency. The institutional and systemic risks of a “real” default are not present. Thus, as inflation and devaluation ravaged the value of the dollar during the 1970’s, for example, no downgrade of US debt occurred, and the global financial system continued to rely on the greenback as its reserve currency without skipping a beat.

With the US able to print its debt service, complaints over the speed of America’s democracy reaching consensus and that demand for an immediate $4 trillion deal seem curious at best. Some clue to the underlying logic might lie in the UK’s retention of its AAA rating despite a higher debt to GDP ratio than the US. Standard and Poor’s justifies this by stating its greater faith in the UK’s political process and Downing Street’s ability to execute its deficit-reduction plan. It is true that Great Britain’s parliamentary system gives far less power to the opposition party than that allowed by the US constitution. Implicitly, it strikes me that what S&P longs for is the stronger hand of an executive, with less of the debate and consensus-building America’s system demands in the name of freedom.

For two centuries and more critics have doubted that America’s raucous democracy could govern, let alone face the challenge of determined rivals. At various times those voices were heard in Kabul, Moscow, Beijing (reprising that song today) Berlin, Tokyo, and long ago even Whitehall. We’ve heard them from our own as well; Joseph P. Kennedy’s “democracy is finished” edict comes to mind. Yet I would argue that the genius of our system is to be found in moments like this, when such disparate and diametrically opposed world views as those of Barack Obama and Eric Cantor can be reconciled to produce agreement – partial, imperfect and requiring further work bur agreement none the less, and, in the end, with the consent of the representatives of the vast majority of the electorate rather than only of a majority ruling by narrow margin over its opponents, let alone of an absolute ruler.

That genius of American democracy can be hard to discern sometimes, over strident partisan voices on CNN and Fox (and today perhaps CNBC and Bloomberg). Perhaps to appreciate this brilliance one might paraphrase Swift’s famous observation, noting that when true genius appears in the world, it may be known by this sign, that the dunces are all in confederacy against it.

]]> http://www.aninvisiblehand.com/blog/?feed=rss2&p=129 0 http://www.aninvisiblehand.com/blog/?p=124 http://www.aninvisiblehand.com/blog/?p=124#comments Wed, 20 Jul 2011 23:08:09 +0000 theorist http://www.aninvisiblehand.com/blog/?p=124 With tax hikes being anathema to many Republicans, and Democrats similarly loath to cut entitlements, some in Congress and the White House are embracing a way to do both without admitting to either. The idea is to change the index used to measure inflation, employing what is known as the chain-weighted or “chained” consumer price index to determine cost of living entitlement adjustments and changes in tax brackets. It turns out this would slow the pace of growth in government programs while increasing taxes, albeit in a manner subtle enough that it may be hoped to go unnoticed by the bases of both parties.

To appreciate the elegance of this bit of statistical legerdemain, one has to understand the difference between the currently-used unadjusted CPI and the chained CPI. The traditional index is often criticized by economists for not taking into account changes in consumer behavior, such as switching purchases from one type of computer to another as technology and/or prices change, or from steak to chicken as the price of beef rises relative to poultry. Historically, measured inflation would have been suppressed by such substitution (by about 0.38% less per year by some estimates), and therefore so would cost-of-living adjustments to entitlement payouts and the CPI-driven ratcheting up of tax-brackets. The prevailing guess seems to be that a shift to the chained CPI would save the government in excess of $200 billion over the next ten years.

Now while swapping chicken for beef may reduce the rate of increase of the index, it does not reflect how happy consumers are about having been forced by prices and budget constraints to make such substitutions – what economists refer to as the change in utility of consumption. All else being equal, so long as consumers can find something to else to eat as beef prices rise – chicken, Spam, Soylent Green (Gen Y readers: look it up) – the government gets to count no increase in inflation nor any diminution in the quality of life*. Thus, under the chained CPI, the cost of living can be re-defined as the cost of surviving, begging the age-old question: “this is living?”

This indifference to reductions in lifestyle means the usefulness of the chained CPI goes beyond allowing a less than courageous Administration and Congress to effectively cut entitlements and raise taxes without admitting to doing so. As I’ve noted before, inflation represents a real default on the debt of the currency-debasing sovereign or sovereigns (see “Europe Learns To Default The American Way, Restoring Transatlantic Balance Of Irresponsibility”). Should a sovereign’s central bank (e.g. the U.S. Federal Reserve) monetize the debt by purchasing government bonds and issuing currency to do so, then defining inflation downward insulates the budget from the upward spending and tax-bracket adjustments that would otherwise occur. This nominal fiscal sterilization of monetizing the debt may be accompanied by some degree of political cover, at least until the electorate gets tired of eating canned tuna instead of salmon filet, or the markets decide the jig is up and start selling off the bonds and/or currency in question. Given the growth path of the U.S. national debt and a Fed balance sheet already bloated with Treasuries purchased under “quantitative easing,” the “soft” default of monetization becomes that much more tempting when the attending inflation is made statistically stealthier.

To be sure, we should give the chain-weighted CPI credit for adjustments it might be getting right, such as changes in the purchase of goods due to technological advancement. However, here too the devil is in the details, for while not including new technology goods fast enough might bias the unadjusted CPI up by neglecting rapid early price declines, some tech purchases reflect the coercive nature of needing to keep up with the state of the art in order to function in society, as with a new television standard or operating system. Many innovation-driven purchases should be regarded not as the ongoing acquisition of ever cheaper, higher quality gadgets but as shocks; that is, sporadic and, to varying degrees, unanticipated additional forced expenditures increasing the real cost of living. After all, while the price of new computers may reflect a decline in the cost of a byte of memory and digital television look better than analog, one cannot function in society with 64K of RAM and an old-standard TV any more than one could now get by using the stone tools of a neolithic hunter-gatherer. The issue is not just improvements in quality but the social context in which they occur, i.e., the cost of living in modern society. Further, a shift in, say, video display buying from 60” flat-screens to cheap tablets might be driven by constrained budgets as much as innovation, and consequently reflect diminished lifestyle. Quality improvement can be in the eye of the beholder, and their subjective nature may give policymakers leeway to define away inflation even as it becomes more acute.

Just to keep government and central banks honest, economists may have to pay more attention to “pain-weighted” adjustments to CPI – the “pained” CPI, if you will, measuring the cost of getting back to the higher standard of living the chained CPI’s calculation assumes we don’t miss.

As the saying goes, there are three kinds of falsehoods: lies, damned lies, and statistics. That aphorism’s origin is disputed but generally dated to the nineteenth century. The Bureau of Labor Statistics, which calculates the CPI, was founded in 1884.

*N.B. for my economist friends: of course a formerly constant utility under a budget constraint (e.g., achieved under minimized expenditure a la Hicksian demand) may be made unobtainable if the price vector changes sufficiently, excluding the prior indifference curve from the feasible consumption set.

Yet risk represents a chance of something happening, not a certainty. A crisis requires more than risk – it needs something to transform the chance of catastrophe into a reality. Given the public debate’s failure to clearly identify the crisis’ ultimate cause, we should look for something of such enormity it might be missed by those inclined to believe all ills are to be found in the petty mendacities of bankers or borrowers, and so frightening that those with understanding dare not speak its name for fear not of some hidden hand’s reprisal but rather of the actions that populaces and nations might take were that understanding to become commonplace.

As its title suggests, this essay argues that a crucial and largely neglected cause of the recent and continuing economic crises is the unprecedented disruption created by the rise of the BRIC powers (Brazil, Russia, and for our purposes especially India and China) and other emerging nations. What I am arguing is that the market rout of 2008-2009 reflected not just a crisis in banking or finance but the first of what may well be many shocks in a noisy process of discounting our collision with resource supply limits to the rate of national and global growth, constraints that are becoming ever more binding, and ever more geopolitically risky, with the continued expansion of the BRICs.

It is true that the two years prior to the market crash of 2008-2009 saw a significant increase in the issuance of US subprime mortgages. By the middle of 2008, these stood at around 10% of an over-$10-trillion US mortgage market. From August 2008 to September 2009 the MBAA reports the percentage of all US mortgages in delinquency or foreclosure rose from 9.2% to 14.4%, or about $ 1.4 trillion. In June of 2010 Fitch put the percentage of subprimes in delinquency at about 45%, or $450 million (yes, the majority were actually not delinquent). This figure implies approximately $1 trillion of non-subprime delinquent mortgages, which is to say more than twice the amount of subpime delinquencies occurred in ostensibly well-documented loans to good credits. Thus the question is begged: what triggered the defaults?

In a similar vein, the repackaging of risky loans by banks who then short those bonds may move risk around to the detriment of some hapless investors, but this does not necessarily increase the riskiness of the financial system as a whole (indeed, that banks get these loans off their books can make them more stable). Likewise, credit-default swaps are essentially insurance against the failure of a borrower to service its debt; these re-allocate default risk between market participants but cannot trigger default any more than taking out auto insurance, in and of itself, can cause a car to crash.

So for some period of time, risky loans were being serviced, swaps, CODs and all manner of financial beasts were on the books and the sky failed to fall. Then something happened.

If one is willing to look, one can easily find that something. The over two and a half billion inhabitants of China, India, and other emerging nations, possessed of the same aspirations as those dwelling in developed North America and Europe, comprise economies expanding at eight to ten percent per year. Their appetites for inputs to production – fuel, ore, grains, indeed almost any imaginable commodity, are growing accordingly. The emerging powers’ consumption of many of these raw materials is now approaching or exceeding that of either the US or EU, which basically means that in coming years the demand for these commodities will have been increased by half with little or no counterbalancing increase in supply. Simultaneously, the rise of the BRICs has explosively increased the global labor supply, and that worker pool is becoming increasingly skilled.

By 2008, the markets, which, after all, are discounting mechanisms, began seriously reflecting not just current but future demand for raw materials, as it became clear that, contrary to their track record in the twentieth century, the BRICs were now serious about growing into first-world status. Commodities, notably oil, spiked, developed nations’ corporate margins compressed and their equity markets began to fall. In the US, the weakest, most-overextended borrowers found simultaneously filling their gas tanks and making their mortgage payments increasingly difficult, especially as they were laid off by firms attempting to compensate for higher raw input prices by cutting payrolls and outsourcing to the cheaper labor of the emerging economies. Default rates rose, squeezing lenders and tightening credit, which begot more distressed firms and borrowers, accelerated defaults, and closed a vicious recessionary circle.

That circle was also briefly deflationary; as global growth turned to contraction, the price of petroleum and other commodities was driven down. Yet less than two years after the peaks of the summer of 2008, with only a relatively anemic recovery underway, we’ve seen the prices of these same raw materials approach or exceed those earlier highs. This rebound, despite tighter regulation, exchange rules and margin requirements, should give great pause to those who’d ascribe that earlier run-up solely to mere speculation.

And indeed that’s the point: the fundamental issue of the rapidly rising demand for raw materials on the part of China, India and others is still with us. (Fortunately the B and R in BRIC are net exporters of key raw materials, and Brazil’s Tupi oil find may keep it that way in the case of the former, at least as far as petroleum is concerned. But this production is swamped by the commodity appetites of India and China.) The effect is a linkage of economic and geopolitical risk that continues to evince itself. For example, increased BRIC demand for grains (for human and livestock consumption as well as fuel) helped drive severe food price inflation in much of the developing world, helping to spark the “Arab Spring” revolutions in Egypt and elsewhere, which in turn increased the risk premium in the the price of oil, further driving inflation risks that now confront central bankers, especially in India and China themselves.

As emerging economies continue to expand, finite commodity supplies constitute ever tighter constraints to growth, limiting the global economy’s expansion rate and creating trade-offs between growth and inflation in individual nations as well as competition between nations for the resources they need to grow. Add downward wage pressure from a vast and increasingly educated emerging nation labor force to international competition for raw materials and you have a recipe for protectionism, militarism and a variety of other unpleasant “isms” that make the world a more conflict-prone and dangerous place (China isn’t building a blue water navy to cruise the Yangtze, nor is its new “over-the-horizon” anti-ship missile some sort of New Year’s firecracker). This potential may explain the reticence among leaders to address these issues in a forthright manner, but avoidance, circumlocution, focus on tangential issues and scapegoating rhetoric will only make it harder to solve the problem and increase the danger of it spiraling out of control.

To be sure, dubious risk control and the failure of key financial institutions, notably Lehman Brothers, needlessly exacerbated the disruption, augmenting it with a liquidity crisis. Note to regulators and taxpayers: when a big bank goes bust, the markets need to know the shareholders will get wiped out (attenuating moral hazard) but credit will be extended so the firm does not default on its liabilities. Otherwise, banks question each others’ solvency, and soon interbank lending and the global credit markets dry up, meaning no one can get a loan. As we’ve seen, with the return of confidence, the capital necessary to accomplish such rescues generally gets paid back quite quickly and with interest.

Likewise, monetary intervention and fiscal stimulus eventually softened the blow. Inevitably, however, the anticipation of the unwinding of these methods limits their long-term efficacy.

All of this, however, pales in comparison to the secular macroeconomic change represented by the emergence of the new economies, not only as regards the causality of the recent crisis but the challenge of managing the international system in a world where finite resources could pit nations against one another, vying for the raw materials necessary for growth while billions of new workers come into the labor force. These are not problems that can be solved solely through financial regulation or even unilateral monetary and fiscal policy. Technology and innovation may eventually relax commodity constraints through the discovery of substitutes and new supplies, while the growth of the emerging economies’ internal demand may eventually absorb much of the new labor forces’ production. This evolution could take decades, however, and in the meantime I suspect unprecedented international coordination and cooperation may be necessary to manage growth and even preserve peace. This will be a process of great complexity, but surely the first step is recognizing the problem.

What of all those risky loans, the US subprime mortgages, distressed assets on the books of German landsbanks, Irish commercial lenders, Spanish cajas and even Greek and other troubled sovereigns? It’s easy to say any asset or investment that winds up performing badly was “too risky” after the fact. Some of these financings may well have been unwise, but we must ask what happened in the world to make them implode. If the cause of the collapse is not understood even after the fact, it’s hardly surprising that the risk of it was not appreciated beforehand.

As the old saying goes, when the tide goes out it reveals all the trash left on the beach. But it is the moon that drives the tide and not the detritus left in its wake. If we fail to grasp the ongoing disruptive and potentially destabilizing effects of the emergence of China, India and other new economic powers, we may find ourselves gazing up at a very bad moon rising.

First, we’ll need some background. Throughout the debate on extending tax cuts to individuals making over $200K, many prior to this writing have pointed out that to not do so amounts to a tax hike on small businesses, with such firms accounting for around 60% of recent job creation in the United States (the increase would kick in at $250K for couples, about the combined salaries of two professors in a major metropolitan area, who would I’m sure be surprised and excited to learn they are now considered among the mega-rich). Indeed, by some estimates, to not extend the cuts would in fact raise the tax on half of all small enterprise income in the country Some argue, a bit disingenuously, that only 3% of small business would be affected, but that’s only because most small firms make little or no money at all; the tax increase would hit hardest that minority of entrepreneurs who in this anemic economy are doing well enough to have some hope of hiring.

And while there is a case to be made that tax cuts for lower earners more efficiently translate into short-term stimulative spending, it’s the saved and invested tax cut dollars of higher earners that tend to fuel longer-term growth in business and hence job creation.

Those in favor of this tax increase point to the ballooning national debt, arguing the country can ill afford tax relief for the entrepreneurial. Using some numbers to put this claim into context might be helpful. Not raising taxes on the so-called higher earners would cost an average of $70 billion per year over 10 years, or $700 billion. That’s about 23% of the $3 billion 10 year cost of extending the cut to the rest of the country (as proposed by the Administration), and well under the $814 billion cost of the stimulus package whose efficacy has been, shall we say, underwhelming.

Given how small the cost of tax relief on those most likely to invest would be when compared to the giant debt rung up over the past two years and the massive borrowing currently proposed, there is little logic in raising taxes on people managing some level of entrepreneurial success in this difficult environment. The truth of this is made especially clear upon consideration of one of the few silver linings to be found in the dark clouds of our economy, that being the government’s remarkably low cost of borrowing.

While risk aversion has abated since the depths of the crisis, many market participants continue to seek the safety of US Treasuries, thanks to a witches’ brew of fear including that of European sovereign and US municipal defaults, real estate overhangs, malfeasance real and imagined and yes, expanded regulation and higher taxes. Pervasive dread has pushed vast capital out of risk markets and into US government debt. You can think of this as the causal obverse of the famous “crowding out” effect, in which increasing government indebtedness pushes other would-be borrowers and those seeking equity investment out of the market. In the present case, the withdrawal of fearful capital from other forms of finance has created a vacuum into which ever vaster quantities of Treasury debt are sucked in, allowing the debt of the nation to be financed at rates at which most small businesses can only dream of borrowing. The past and potential purchases of Treasuries by the Federal Reserve under the banner of stimulative “quantitative easing” has (so far) served to further lower the yields on Treasuries. As of this writing, yields on 10 and 30 year Treasuries are about 2.5% and 3.75%, respectively, and this at a time when the implied inflation rate based on inflation-protected “TIPS” bonds is between 1.75% and 2.25%, making the expected real return on Treasuries slim indeed.

Thus the Treasury could fund tax relief for small businesses by effectively borrowing on their behalf at long-term fixed rates unattainable by them on their own, allowing the income of those enterprises to be reinvested. At these low fixed rates, with luck and limited further economic mischief in both the public and private sectors, there’s a reasonable chance the return on that capital will substantially exceed the cost of financing, facilitating the service of the added debt through the taxation of profits.

Some will complain this prescription further elevates a borrowing trend which is long-term unsustainable. I agree, but the increase is slight compared to the overall growth in the debt, which will in the end have to be addressed by other measures, including (dare I speak its name?) spending cuts, even in entitlements. Others will note the increase in Treasury issuance and the Fed’s purchases of same raise the specter of debt monetization, potentially driving up rates, weakening the dollar, and increasing inflation. Again that is true, but, the fact remains right now the world is willing to let the US lock in its financing at rates that seem to ignore this possibility.

Finally, there are those who will say I propose using the public credit to gamble on American entrepreneurship. Perhaps so, but given that we just bet over eight hundred billion dollars on, amongst other things, Amtrak and a combination of Chrysler and Fiat, I’d say my proposed wager is hardly the most speculative the nation has been presented with. Its time to give small business a chance.

By ignoring much of the potential impact of a sovereign debt crisis on the solvency of Europe’s banks, perhaps the regulators who ran the so-called stress tests released today were trying to send the world the message that they don’t take the possibility of a eurozone sovereign default seriously, and neither should the markets.

In conducting the tests, the Committee of European Banking Regulators and the European Central Banks assumed various haircuts on the values of Greek, Portuguese, Spanish and German debt, but applied these only to the trading books of the examined banks, not to their loan portfolios. In effect, this assumes that the impact of a contemplated crisis will be limited to a short-term liquidity discount on national obligations, but that any bonds held to maturity will in fact pay off in full. Indeed, Bloomberg quotes ECB vice president Vitor Constancio as saying a sovereign default scenario was not included because “we don’t believe there will be a default.”

As a result of this and other arguably dubious assumptions (apparently including parallel shifts in the yield curves of eurozone members – one would think such movements might be quite different for a defaulter as opposed to other euro nations) only seven of the ninety-one banks examined failed the tests and will be required to raise more capital.

Now the eurozone regulators’ gambit only works if the markets are convinced that member nations’ governments really have the will and means to prevent a true sovereign default. In fairness, recent EU and IMF lending initiatives combined with fiscal restructuring in nations including Ireland, Spain and to some extent Greece have lent support to the euro and European debt markets. However, by banishing true sovereign default from their realm of contemplated possibility, the CEBR and ECB have put far more of the responsibility for European (and global) banking stability back in the hands of Europe’s politicians. Banking on the vicissitudes of political capitals as opposed to increased bank capital might itself be a potentially risky move.

]]> http://www.aninvisiblehand.com/blog/?feed=rss2&p=98 2 http://www.aninvisiblehand.com/blog/?p=94 http://www.aninvisiblehand.com/blog/?p=94#comments Fri, 14 May 2010 01:18:33 +0000 theorist http://www.aninvisiblehand.com/blog/?p=94

The game-changing aspect of the eurozone member states’ plan to stabilize the euro is not the $139 billion Greek bailout or the trillion-dollar currency stabilization fund per se, but rather the about-face of the European Central Bank, which will now reverse a longstanding policy and purchase the debt of euro states. In doing so, the ECB and its president Jean-Claude Trichet, have opened the door the the monetization of euro sovereign debt, which is to say the effective real default implied by inflation and currency debasement.

In essence, the ECB can now create euros to buy Greek or other European debt, including cross-eurozone bonds issued to finance the euro stabilization war-chest. Since that fund could borrow to support the euro and the ECB can purchase that debt as well as the bonds of individual euro nations, the net effect is to allow the assumption of a distressed member state’s debt by the entire euro membership and the inflating away of that debt through euro creation on the part of the ECB.

If all this sounds familiar to American ears, it should, since the power to monetize dollar-denominated debt has long been possessed by the central bank of the “dollar zone,” that being of course the Federal Reserve. Indeed, most central banks around the world have the ability to inflate away debt denominated in the currencies they create. A crucial difference between the ECB and its brethren has been that sovereign borrowing in the currency over which it presides has been done by sixteen individual states, and that debt has until now been off limits for purchase and thus monetization. The analogous situation in the U.S. would be if all government borrowing were done by the individual states through municipal bonds.

Now, monetization with its attendant inflation and devaluation is indeed a form of default, since in real terms debt holders are paid back in money which will now buy less goods, services and foreign currency than it did when it was lent. Yet even if bondholders are burnt in terms of purchasing power , there are certain systemic advantages of real default over the nominal variety, in which lenders are paid only a fraction of the currency (euros, for example) which they are owed.

Consider banks borrowing from depositors in euros and lending to eurozone governments by buying their bonds. In a nominal sovereign default, the bank might not have enough euros to pay back its depositors, which is the kind of thing that tends to lead to bank runs. But in a monetization-driven real default, the bank gets paid in full and so do the depositors, albeit in a debased currency. Banks’ and depositors’ euros might not be worth much but they get each and every one they are owed. Financial institutions’ balance sheets may shrivel in real value but they continue to balance, avoiding runs and some types of systemic shocks.

Similarly, and rather paradoxically, the certainty of nominal payment under real default has at least one “operational” advantage in the creation of the reserve currency the eurozone members would like their currency to become: knowing the ECB can print euros to pay off euro debt, the world’s central banks can invest the currency in assets whose nominal return can be calculated with more certainty, as can future holdings of the currency itself. Again, the future value of that currency may be in question but not the amount of it to be received.

The balance sheet stabilizing aspects of real default can come at a high price, including the destruction of savings’ buying power, growth-killing price uncertainty and, as demonstrated in the Europe of the 1930’s, social unrest and war (this has something to do with the reticence of Germany in regard to the euro rescue, as evinced recently in the Westphalia vote). Inflating away debt is a treatment best administered sparingly, if at all. How much tolerance electorates of more solvent euro nations have for being taxed to pay the bills of their less productive, more profligate neighbors may well end up the determining factor for the euro’s survival, at least in its current form.

One silver lining for the Europeans (at current prices a golden one would be too much to ask for): with both the U.S. and Japan up to their eyeballs in government borrowing, the real default risks of dollar, euro and yen sovereign debt could at least partially negate each other in a rough balance of fiscal and monetary irresponsibility. And if these currencies’ mutual risk of debasement puts more pressure on China to revalue the yuan, I can almost hear a chorus of finance minsters singing hallelujah.

It’s worth mentioning that, in the wake of the Fed’s recent broad-spectrum asset purchase programs, we may yet see the day munis are added to that central bank’s balance sheet. After all, even a casual observer of the disconnect between California’s entitlement-driven spending and any realistic projection of its tax revenues could be forgiven for viewing Athens as simply Sacramento on the Aegean.

Addendum: Those of you who enjoyed my rather skeptical remarks on the role of swaps in the Greek crisis (“Greece And The Zen Of Credit Default Swaps”) may also enjoy a similarly-minded piece by Stefan Schultz in Der Spiegel, in which I’m quoted extensively. One caveat: it’s much more enjoyable if you happen to read German; if not, should you paste it into a translator program, note the amusing fact that Trester is the German word for wines otherwise known as marc or grappa, which is how my surname may be automatically translated.

If a nation is insolvent and no one knows about it, will it still default?

The implication of arguments in an article in today’s New York Times (“Banks Bet Greece Defaults on Debt They Helped Hide”) appears to be that the answer is no. The idea seems to be that because investors can use credit default swaps to insure against insolvency and learn from the price of that insurance what the market’s perception of default risk is, that default itself becomes more likely: “As banks and others rush into these swaps, the cost of insuring Greece’s debt rises. Alarmed by that bearish signal, bond investors then shun Greek bonds, making it harder for the country to borrow. That, in turn, adds to the anxiety — and the whole thing starts over again.”

The key word here is anxiety, because the CDSs themselves can’t cause a default – they’re not an obligation of Greece. It’s the information they reveal about the riskiness of Greek debt that’s the issue – as the price of CDS insurance goes up, investors know the market believes the probability of insolvency has increased.

As the title of the ‘Times piece indicates, banks and the Greek government have been under fire for supposedly concealing the extent of Greek debt and thus hiding form the world the odds of Greek default. Now financial institutions are simultaneously being slammed for doing exactly the opposite: revealing to the public the riskiness of Greek bonds through the pricing of insurance against their default. That’s a bit too much hypocrisy for one financial crisis.

Indeed, if one were to blame the information revealed by CDS pricing for the sell-off of Greek debt, one might as well also blame the credit rating agencies for threatening to downgrade that nation’s debt rating, which has had the same effect. Aren’t these the same folks we were criticizing a few months ago for not ringing alarm bells fast enough?

The truth is much of the extent of Athens’ debt has been known for years, so when recession hit the market questioned Greece’s ability to pay. As the Greek economy has slowed, banks and other investors quite reasonably concluded that a county whose national deficit exceeds a staggering 13% of GDP (more than four times the EU limit!) is spending far beyond it’s means, with insufficient productivity, national income and tax revenues to cover it’s vast social spending. This is why the EU has also shied away from committing to a bailout of Greece; and, after all, many other European nations have similarly unsustainable spending and debt levels relative to national income.

If governments are ever to get their fiscal houses in order, they must not be allowed to obfuscate their irresponsible actions by pointing fingers at those who lent them money, insured against their failure or simply informed the world of the chance of default. If we allow them to confuse the issue in this way we do them, and ourselves, a great disservice.

Addendum: In a spot-on piece, Shannon D. Harrington of Bloomberg points out that “Greece Credit Swaps ‘Cabal’ May Be Just Sideshow”, arguing that credit default swaps spreads were more an “canary in a coal mine” as opposed to a cause of the crisis, and that “The credit-default swaps traders being blamed by German and French leaders for fueling fears of sovereign debt crises would be doing so with less than 1 percent of the governments’ outstanding debt being wagered…In Greece, where the heaviest complaints about credit-swaps trading have been leveled, bets of $9 billion compare with $267 billion of debt.”

I’d go even further, noting that the ability of the notional value of bets on the occurrence of a credit event to actually change the odds of the event is itself at least questionable. Even if the notional amount were on the same order as the debt itself this may simply reflect the borrower’s precarious position as opposed to influencing it. Some argue the CDS amount (and price) dissuade potential lenders, but even if investors couldn’t bet on a default it hardly implies they wouldn’t learn about the risk by other means much less turn around and lend to a risky credit. To the contrary, the fact that they can lay off that risk in a CDS or similar hedge may be the only reason they’d even consider additional lending.

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